COVID-10 Diary Number 7 (July  8, 2020)

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Would negative interest rates help the economy recover from anti-virus strictures and propel the stock market rally?  President Donald Trump seems to think so.  He has publicly pressured Federal Reserve Board (Fed) Chairman Jay Powell to pursue just such a policy, saying that the country deserves the “gift” of below-zero interest rates.  Though the Fed has readily brought short-term rates down to nearly zero, it has thus far resisted moving them still lower. Powell has said that the monetary actions already in place will do a better job of fostering a strong economic recovery.  In this dispute, the weight of economic good sense would seem to lie with the Fed, but the struggle will turn more on political than on economic matters, especially on the political optics of an economic re-opening.

Before examining prospects for negative interest rates or the reasoning on each side of this debate, let’s review exactly what negative interest rates are.  They do not demand, as some have suggested, that banks or other lenders actually pay borrowers for the privilege of extending them credit.  They are instead a result of movements in bond markets.  Here is how they work:  A government or a large and secure corporation issues a bond at a very low coupon –– that is, stated –– interest or with no interest attached to it at all.  Effectively, the issuer promises the bond buyer to return only the initial amount borrowed when the bond matures.  When bond buyers are flush with cash and also have concerns about defaults on anything but the most secure credits, they could so increase the demand for such quality bonds that they bid their price above the amount that the borrower promises to repay at maturity.  These bond buyers then, if they hold the bond to maturity, will get less back than the premium price they paid for the bond.  That constitutes a negative interest rate.

Trump’s motivations for making his demands are clear.  He wants to get re-elected and thus wants as much immediate economic stimulus as possible, regardless of all other considerations.  In this respect Trump differs not at all from all presidents before him.  He may feel even more such pressure than past presidents because he will have to carry the lingering economic effects of the pandemic into his re-election campaign.

But the Fed is not running for office and so it takes a broader, longer-term approach to policy, as its charter demands.  Thus it views negative interest rates through the prism of at least four considerations:

  1. It can see a need for stimulus to bring the economy back after re-opening, and it recognizes the immediate stimulatory potential of negative interest rates.
  2. It can also see –– from the experience of other countries –– that negative interest rates have more often than not failed to generate much economic response.
  3. The Fed also worries that negative interest rates will distort financial decision-making, because their unusual nature can undermine the rules of thumb and formal algorithms commonly used by traders and investors.
  4. An additional concern is that negative rates now will strain bank finances, especially because the anti-virus quarantines and lockdowns have raised the risks of corporate defaults and bankruptcies.  It is not that the Fed wants to protect bank profits, but rather that it wants to avoid the kinds of financial failures that plagued the Great Recession economy in 2008-09.

Although neither Powell nor other Fed governors have mentioned it, there is also concern about the harm that negative interest rates might visit on business confidence.  Because the returns offered in financial markets naturally reflect returns available in the larger economy, a policy that pursues negative rates effectively announces that economic prospects are limited.  The relationship stands to reason.  When returns to economic endeavor are high, businesspeople will happily borrow in order to pursue those returns and that borrowing in turn will push up lending rates in financial markets.  When returns to economic endeavor are low, business has no appetite for expansion or for borrowing, no matter how low interest rates are. Low and especially negative returns hint at this sad economic condition.  When countries such as Japan and Germany pursue negative interest rates, they suggest some deeper economic malaise, perhaps the need for regulatory reform or a change in trade policy or in labor law to raise returns available to economic endeavor.  Monetary policy, even if it forces negative interest rates, cannot answer such needs. To be sure, very low interest rates say something similar, but negative rates are a thing apart.

With all these considerations in mind, Chairman Powell has countered the president’s pressure by pointing to the lower risks and greater efficacy of monetary policies already in place.  After all, the Fed has brought short-term interest rates down to nearly zero, so that it is effectively costless or very inexpensive for businesses to borrow.  Under the broad heading of “quantitative easing,” the Fed has also entered financial markets through a number of programs to provide copious liquidity for individual and business borrowers, as well as municipalities and states.  All these measures should help protect the stability of financial markets, Powell contends, and promote a robust recovery as anti-virus strictures lift.  They will do so, he implies, without the distorting risks introduced by negative interest rates.

Whatever the economic fundamentals or the experience abroad, the dispute between the president and the Fed will play out in the political, and not the economic, arena.  If the economy responds smartly to the re-opening efforts, a gratified Donald Trump may look at the coming election with greater optimism.  Needing less help from monetary policy, he may likely ease the pressure on the Fed.  But if the economy fails to respond adequately to the re-opening and unemployment remain high, Trump, in his increasing desperation, may redouble the pressure on the Fed, making negative interest rates a greater likelihood, regardless of the reasonable reservations of Chairman Powell and the other Fed governors.